Flashpoint

By Greg Holden, IRI Business Writer

Innovation: the greatest engine of economic growth, prosperity and job creation. Although business leaders acknowledge this superlative description as true, is it possible that our way of managing for technological innovation is wrongly configured? Does our current approach to tech innovation make us too afraid of upsetting shareholders to be truly innovative?

Ron Ashkenas, a Senior Partner for Schaffer Consulting, argues in a recent Forbes article that managers today actually fear innovation for three reasons: their need for immediate results, their fear of cannibalizing existing businesses/products, and their educational upbringing which emphasizes slow, continuous improvement over drastic changes. This adds up, he says, to business leaders being incapable of making the hard choices necessary to truly innovate. These are all valid points, but is there a way to simplify this erudite position even further?

In his keynote address at IRI’s Diamond Jubilee this past May, Harvard Business School professor Clay Christensen walked attendees through a story he has told before. It is the story of how the “church of finance” and its “high priests”—business school professors like himself—have created the demise of our economy: mechanisms for evaluating investments and company value through a handful of ratios, like internal rate of return (IRR) and return on net assets (RONA).

As he explains, this allows business leaders to look at their company’s net value through different lenses. Through one lens, value can be increased by improving the numerator of the ratios; that is, creating new, profitable products or businesses. This usually requires substantial capital investment and a lot of time to perform the necessary R&D. But through another lens, leaders approach such decisions with an eye on the denominator of the ratios. For RONA, the denominator is assets. Therefore, we can improve RONA by lowering the denominator through such actions as outsourcing—i.e. cutting jobs. For IRR, the denominator is time. The faster an investment pays off, the better IRR looks. We can improve our IRR, therefore, by investing in shorter-term projects.

Such an approach to valuation leads many business leaders to opt for the project which minimizes assets on the balance sheet and delivers the quickest returns. The side-effect is what you would expect: organizations rarely willing to invest their capital in the development of risky, disruptive technologies—the kinds of technologies that spurn job creation, according to Christensen. Since little capital is invested, it accumulates and depreciates in value. Over a long enough period of time the price of capital drops to zero, but these same organizations’ stock prices—as determined by investors evaluating a company through ratios like RONA and IRR—look beautiful to shareholders, who then reward company CEOs with huge bonuses.

As Christensen remarks at another point in his talk, “Think about the implications of the cost of capital being zero. What meaning does return on capital have? And we calculate net present value; what meaning does that have if the cost of capital is zero? What used to be right in an era when capital was scarce and costly [i.e. the 1940s, 50s, and 60s] is just irrelevant. Nonetheless, companies keep investing as if the old rules are applicable.”

Moreover, since investors, as Christensen argues, tend to adjust their stock portfolios according to a company’s worth as deemed by ratios like IRR and RONA, this behavior is being reinforced externally in a way that imitates a vote of confidence by consumers. But is it? Shareholders usually do not have access to how the company’s leaders decide to improve their ratios. So, while a company may look profitable via its stock price, it could in fact be cannibalizing itself through outsourcing its core competencies in order to reduce its assets, or opting only for those projects with short-term payoffs, or both.

The worst part is that the business leaders making such decisions rarely understand that they are undermining their own business units until it is too late. They too evaluate their company’s success through ratios like IRR and RONA, says Christensen. As long as stock prices are going up, they look good and believe they are doing their job well. Since short-term success is all that’s called for in order to receive their bonuses, there is little accountability for long-term failure.

Touching on the same theme as Ashkenas and Christensen, Steve Denning, author of The Leader’s Guide to Radical Management, penned an article where he wrote that “the focus on short-term value and the stock price gained traction in the 1970s and 1980s, supposedly as a way of advancing the interests of shareholders and protecting them against the greed of self-serving managers. It was called shareholder value. But the approach had the opposite effect of what was intended.” Instead of protecting shareholders, it created an even worse disease Denning labels “C-suite capitalism.”

Citing Roger Martin’s Fixing the Game, Denning continues, “Between 1960 and 1980, CEO compensation per dollar of net income earned for the 365 biggest publicly traded American companies fell by 33 percent. CEOs earned more for their shareholders for steadily less and less relative compensation. By contrast, in the decade from 1980 to 1990, CEO compensation per dollar of net earnings produced doubled. From 1990 to 2000 it quadrupled.” The end product is a game played by top-level executives to squeeze as much out of an organization as possible in as little time as possible in exchange for a multi-million dollar bonus, regardless of the company’s ability to compete in the long-run.

As Christensen, Ashkenas and Denning (and several others) argue, a need for short-term results is not the only negative side effect of business thinking today. A focus on eliminating the use of capital to streamline organizations, through what Christensen calls efficiency innovations, has also eliminated the private sector’s desire to invest in local infrastructure and the public sector, weakening the mechanisms through which society develops its workforce and constructs intricate networks of product and service companies in close proximity.

Each of these men argues that we need to begin addressing not just the side-effects of our current economic woes, but the root causes. The biggest root cause, they argue, is business leaders’ fear of a drop in stock price. A lesson from the past may serve us well here. The purpose of a business, as argued by Peter Drucker in 1973, is not to create goods and services, but to create customers with the goods and services offered. Have we lost sight of this goal? Why are we becoming complacent with not creating customers in order to look good to investors—those whose interests (i.e. personal profit) lie beyond a company’s long-term health?